Futures-Backed Bitcoin futures have demonstrated themself a dramatically successful product, even if they have some very peculiar drawback that makes them a subpar instrument compared to cash backed Bitcoin ETF’s, which, for the moment, aren’t allowed (or going to be allowed) by the regulator.
The First Futures Bitcoin futures blacked ETF to launch has been Proshares’ Bitcoin Strategy ETF (BITO), which managed to hoard more than 1 Bln Assets Under Management in less than three days: the fastest ETF to reach this threshold.
Let's analyze how it works.
BITCOIN STRATEGY ETF
Website Prospectus Factsheet:
Here there is the Fund-s factsheet, describing his mean features:
https://www.proshares.com/media/fact_sheet/ProSharesFactSheetBITO.pdf?param=1637843142072 
From these few lines we can highlight the main feature of the fund:
The fund seeks capital appreciation
This vague statement is quite different from what you would find on a standard ETF term sheet. Those documents usually report something like:
Something like:
The Fund ProShares X seeks investment results, before fees and expenses, that track the performance of the X Index.
This means they adopt a purely passive approach (bar a very few highly specialized actively managed ETF’s).
The fact that they don’t clearly state this “track” statement in the objective fund is indicative of the fact that they surrendered to the fact that tracking is quite a difficult objective to achieve, even before fees and expenses. The fund holds exposure to Bitcoin futures contracts only
The fund invests in Bitcoin futures to hedge their exposure to Bitcoin. They have the theoretical possibility to use other instruments, like equities of other instruments, but this is on a last-resort basis. Using futures instead of the underlying spot bitcoin means that the position must be actively managed, to say the least, roll the position each future expiry. This has implications on the expenses of the fund, as we will see. The fund doesn’t invest directly in Bitcoin
The future is not allowed, due to regulatory constraints, to directly invest in “physical” bitcoins. As the future is cash-settled, even if they somehow take delivery of the future, they will never end up with physical bitcoins in their portfolio.
ETF Basics: Shares issuance/Destruction
Bitcoin ETFs trading is facilitated by Market Makers, subjects that provide the market with liquidity, or continuously updated prices and quantities for the investors to buy and sell the ETF. When an investor wants to buy an ETF share, will put in competition the prices of the various market makers on the exchange. Each market Makers continuously quote a pair of bid/offer prices for the ETF, that will be provided according to their peculiar models regarding underlying price and liquidity, willingness to reduce their inventory, and any possible other price-sensitive factors. When an investor decides to buy an ETF share and trade with the best pricing market maker, he will transfer the cash to the market maker, that in return will transfer the ETF in case of a buy (vice versa in case of a sell, the investor will transfer the ETF share against the cash). This simplified version of the trade requires the share already being issued and in possession of the market makers, to be transferred to the buyer through the exchange. In the event this is not the case, the market maker will have to go to the ETF issuer in order to obtain a new ETF share, against the corresponding cash amount. This process is called “share creation” or “share issuance”, and happens when the number of shares bought exceeds the available shares sold. Of course, the opposite phenomenon can happen, and it is called “shares destruction”. Please note that this creation/destruction process always happens “in-kind”, or against cash, not against futures as market makers transfer cash to the ETF issuers rather than futures.
As the share creation/redemption process is not instantaneous, or actually is quite slow, each market maker will maintain a certain quantity of shares in their account, maybe also hedging their value against the underlying market, in order to timely provide liquidity to the market. Looking at shares creation/destruction we can have a precise idea of funds flowing into and out an ETF, as the AUM is a misleading guide, as it can grow bigger without new fund inflow, being influenced by the underlying price dynamics (something like GBTC reaching record AUM without new subscribers being fund’s subscriptions being closed since the beginning of this year).
Future Backed ETF. How they Work
The main Feature of Bitcoin ETFs approved by SEC so far, is the fact that they track the future underlying price, or the CME reference Index in case of BITO. According to the SEC, approving ETFs under the 1940 Act, limiting approval only to future based ETFs means more protections for investors. Also, in their opinion, this is the only possible approval, as the fact that Bitcoin isn’t a security, makes it impossible for them to approve a physical bitcoin ETF under the less stringent 1933 act.
As the ETF has to replicate an index tied to CME futures market, the most effective way to do so is to buy the Futures quoted on that index, with a specific ratio in order to match the exposure given by the shares.
The problem is there is a huge cost in this kind of strategy. While the underlying index is continuous, futures have a designed maturity, and when this maturity nears, the issuer has to roll their exposure to the next expiry month. Rolling the exposure means selling the front month (the future with shorter expiry) to buy a longer maturity one (back month future). The price difference between the two contracts is actually a transaction cost.
In particular, given the peculiar microstructure of the Bitcoin market, the future price structure is upward sloping. Something called contango, as we explained in the thread:
Everything you wanted to know about BTC futures but were afraid to ask! |  |
| Fig.1. The Bitcoin Future Curve exhibits a steep contango. This has been true since its inception. |
Each dot in the above graph, bar the one in the left which is the current spot level, represents a future expiry: as you can see going further on longer maturities the price increases. Just remember this has
nothing to do with the expected future price of bitcoin, but it's something intrinsically determined by the market microstructure, as explained in my Future thread: future prices are not an unbiased prediction of the future spot market.
Being the future curve in contango, this means that every time the issuer rolls the position to longer futures, he has to sell the shorter, lower priced future, to buy the longer, higher-priced future. The whole operation imposes a loss, that will be passed to the investor, as a reduction to the NAV.
This cost is not constant, but depends on the shape of the futures curve structure being higher with steeper curves, and lower with flatter curves.
Since the launch of the ETF we have seen the future curve move quite a lot, as we can appreciate from this graph:
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| Fig.2. Contango curve has been quite traded since ETF inception, and reached its' maximum on the same date of the future roll. |
From the initial situation before the announcement of the ETF, the blue line, which exhibited a small contango, simply the advent of a future based ETF sent the curve in a steeper contango (red Line, sampled on ETF launch date). Then, at the first roll, the contango got its's height, as the ETF itself was buys buying longer dated future and selling front months. Yesterday the situation was somewhat mixed, having just completed their second roll, for the moment the situation is not at the extremes.
In the below picture we can see an estimate of these costs, and we see that in the past years it has been also at around 10%.
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| Fig.3. The Bleed Index is a way to measure the cost of the rolling the activity to longer futures. |
This roll cost is a burden on the ETF performance: in case the roll cost is 10%, all other things being constant, the ETF will underperform Bitcoin Price of this 10%, in addition to the standard management fees.
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| Fig.4. So far, the fund has been quite successful to replicate the underlying bitcoin Future. Even if they rolled two times, they are still in pace with the underlying performance. |
If the ETF will be particularly successful it will probably have to scoop up a lot of futures, pushing the term structure even more in contango, thus raising its own roll cost. This negative feeding loop can be mitigated via another class of investors, who will try to benefit from the excessive level of contango selling the future to buy the spot. This trade is a cash and carry trade, and we talked about it here. The buying force of the ETF share creation will push the future curve in contango, while the “cash&carry community” will push the curve back to a normal level. Eventually, the market will find an equilibrium where those two opposing forces will equate themselves.
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| Fig.5. CME Commitment of Traders |
We see that the hedging community got a record short future position at BITO launch. This position is the result of the selling pressure on the future curve to counter the buying from BITO. BITO has to buy the future, while the hedging community sells the future against buying the underlying.
Of course probably someone is servicing this "whole package" to BITO: they are selling futures to BITO while buying the physical underlying (Something BITO cannot do) and cashing in the cash and carry roll.
For example this is the holding of BITO on a typical day:
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| Fig.6.BITO fund Holding on Nov, 29 | Fig.7.BITO fund Holding decomposition |
As we see, BITO Is Holding 3803 front Month Contract, plus 1109 Back Month Contract. These 4,912 contract are equivalent to 24,560 BTC, as a single CME future controls 5 bitcoins. As on the same date, the BRR BTC index was @58,470, these BTC are equivalent to USD 1,436,023,200.
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| Fig.8 AUM is simply the NAV times the Outstanding Shares Number |
From the BITO website we know that on the same November 29th, the NAV was at USD37.08 with 38,830,000 shares outstanding, with a AUM equivalent to 1,439,870,762.
As you can see, the futures in BITO account perfectly match the AUM exposure.
OF course, as the futures don't require to pay the whole premium, but only a percentage of this, into the BITO account there are also a number of cash instruments for liquidity management: these instruments are meant only to reinvest the cash portion of the ETF, not used to buy and margin the futures.
As we read on the prospectus:
- Money Market Instruments — The Fund invests in short-term cash instruments that have a remaining maturity of 397 days or less and exhibit high quality credit profiles, for example:
- U.S. Treasury Bills — U.S. government securities that have initial maturities of one year or less, and are supported by the full faith and credit of the U.S. government.
- Repurchase Agreements — Contracts in which a seller of securities, usually U.S. government securities or other money market instruments, agrees to buy the securities back at a specified time and price. Repurchase agreements are primarily used by the Fund as a short-term investment vehicle for cash positions.
As you can see fund's assets (futures and other bonds) are pretty much aligned with fund liabilities (AUM). The funds actually tries to maintain those two numbers quite aligned, even if the market is taking a momentum, in one direction or the other:
The Fund does not take temporary defensive positions. The Fund will generally hold its bitcoin futures contracts during periods in which the value of bitcoin is flat or declining as well as during periods in which the value of bitcoin is rising.
In other words, BITO is a passive strategy.
At the moment we see that the Bitcoin ETF has chosen to better replicate the index price dynamics, using only the front-month futures to track the underlying price. This accuracy in replicating the index has the drawback of being more costly to execute, being exposed to greater roll costs. A different strategy implies using more distant futures on the curve trying to reduce rolling costs, with the drawback of a less precise tracking price.
As the fund grows bigger, the position held at the ETF can grow up to the limit imposed by the exchange itself. CME has already raised the limits once, and it’s difficult they are going to increase them again soon: at the moment the CME is allowing 4,000 contracts for the front month and 10,000 for the back months.
ProShares Seeks Waiver From CME for Position Limits on New Bitcoin Futures ETF: ReportStarting with the November front-month contract, the Chicago Mercantile Exchange (CME) will limit the number of futures a buyer can buy in the new ETF to 4,000, dropping to 2,000 three days before expiration. As each contract represents five bitcoin, total ownership is limited to 20,000 bitcoin.
To get around this limit, ProShares has already split its futures portfolio, with half in October and half in November.
CEO Michael Sapir told Barron’s that if the CME doesn’t grant the waiver, ProShares could shift assets into later-dated contracts, structured notes or swaps. Barron’s also noted that ProShares’ prospectus for the ETF says the fund could also invest in equities with crypto exposure.
Currently, Proshares is hedging their position not only with the front contract, but, as they have reached position limits, or very close to it, with the back months. In case of the growth ok size he will have alternatively to buy other futures rolling up into the curve (sending it further up in contango) or resort to some other instruments, explicitly allowed in the term sheet as swaps, where they write a derivative with a counterparty to receive bitcoin appreciation. As they are an actively managed ETF, they haven’t any regulatory constraint of which future expiry to hold, but as we saw, there is a tracking error holding longer-dated futures.
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| Fig.9. Futures Hedging. Rolling future Exposure |
In above Fig. 5 you can see how BITO hedges their AUM. They buy the front month future until the position limit has been reached, they start buying the back month(s). When the front future expiry date nears, they start selling the front month while increasing back month positions, effectively "rolling" their exposure further down the curve.
As the funds’ holding is very well known amongst the public, competitors included, having a too big a position to roll in the last days before contract expiry, could expose BITO to liquidity issues, as other market participants could try to squeeze the rolls (making it artificially dear), knowing that BITO would be forced to roll the positions whatever the cost.
The success of BITO had a somewhat mixed effect on competition, on one hand, there are now three authorized futures-backed ETFs: Proshares Bitcoin Strategy FUND (BITO), Valkyrie Bitcoin Strategy Fund (BFD) and the newly authorized Vaneck Bitcoin Strategy (XBTF). The competition has already started grinding margins, with the latter ETF sporting a lower net expense ratio of 0.65%, compared to others’ 0.95%.
On the downside, BITO has been so successful that many issuers abandoned their plans to list a futures based ETF (take Bitwise, for example, who scrapped their Future Based ETF initiative a couple of Weeks after BITO launched), as BITO is seen cannibalizing the whole demand.
In fact, while the industry is seen to gather up to 10 BLN of AUM in the first year (equivalent to a cumulated fee in the 100 million USD ballpark), we have already seen in other countries like Canada, where Purpose Investment has a solid leadership, that there is a clear first comer advantage in this kind of instruments.
Probably now the battlefield is the physically-backed ETF, the future of which is still pretty much unclear, as the SEC is lagging behind, and refusing to provide authorisation. Bear in mind that many physically-backed ETF-like instruments are already being traded in Canada, Europe, Australia and elsewhere, so the SEC is actually holding back US investors from this investment possibility.
There is actually a huge demand for this kind of instrument, as many investors cannot touch the real things, be it for regulatory, compliance or investment mandate issues. Many investors might also be concerned by the fiscal, accounting and auditing issues of cryptocurrencies accounting into balance sheets. Not to mention all the technical and legal aspects tied to custody, either through self-custody or a professional custodian. For all these subjects a financial proxy like a physically-backed ETF would be a huge facilitator getting Bitcoin exposure..
As the subject is quite broad, I had to cut short a few details or aspects, please let me know in the post below if there's something else you would like to know in greater details.
Additional Resources:
